From Academic to Actual: Currency volatility and the real economy

By Chris Harvey - January 29, 2012

In April 2011, my Deloitte colleagues and I, together with the World Economic Forum, put on our binoculars. We, like others passionate about risk to the global economy, looked at the topic of currency volatility and the international monetary system, and saw a potential period of instability. At that time, it could still be argued academic. Today, it is clearly very real. As we begin 2012, the level of uncertainty in international currency regimes is now front and center. We are a long way from the U.S. government’s former AAA debt rating, Italy’s four percent bond yields, and a time when few analysts were seriously discussing any kind of “landing” in the Chinese economy, be it hard or soft.

Markets are now driven predominately by macroeconomic developments, and systemic changes to the global economy seem to lurk behind every new policy announcement. It is clear that studying possible evolutionary paths of the international monetary system has moved out of the realm of academic discussion and into the real world in a way financial services providers cannot afford to ignore.

It has been clear for some time that banks and other financial institutions need to have the necessary financial resilience to weather periods of increased volatility and disaster scenarios like the dissolution of the Euro. But this requires proactive steps. These institutions need to prepare themselves to ensure this type of resilience.

In that vein, an interesting new trend we are observing is a growing interest among “real economy” businesses to develop mitigation strategies in this increasingly unstable economic environment. For example, the CEO of a major logistics conglomerate joined CEOs from numerous global banks, insurance companies, and hedge funds who attended our Davos session. These types of businesses are increasingly looking for advice on how to structure their financial dealings in response to this uncertainty. And here is where there is another opportunity—that of financial institutions to play the role of trusted advisor.

In the aforementioned session where members of the Deloitte network worked closely with the World Economic Forum, we brought together central bankers, ministers of finance, representatives of Bretton Woods institutions, economists, and the CEOs of global banks to discuss likely scenarios around the long-term implications of critical currency fluctuations—namely the Euro, Dollar, and Yuan. Astute observations and major lessons resulted from these gatherings. The following are some highlights:

The Euro – There is a need to begin, in earnest, the work of building the necessary governance mechanisms to ensure that the crisis surrounding the Euro is not repeated. And the Euro-zone must explore pathways to growth and competitiveness, particularly in the periphery, if the Euro is to take on an increased international role. However, participants at our sessions were increasingly optimistic about the future of the Euro-zone and believed that the risk of a total collapse had significantly decreased (though the possibility of one or more nations leaving the Euro-zone remains very real).

The Dollar – Participants widely acknowledged that there was currently no real alternative to the U.S. Dollar; the Euro’s structural problems remain very real, the convertibility of the Yuan is highly restricted, and markets for alternative currencies such as the Swiss Franc or Canadian Dollar lack the necessary depth, breadth, and liquidity to compete with the U.S. Dollar. However, in the event that a competitor emerges faster than expected, the U.S. Dollar could quickly come under serious scrutiny given the current state of the U.S. government’s balance sheet.

The Yuan – The Yuan won’t become an international currency overnight. Liberalisation of interest rates and capital controls, as well as the development of robust Yuan-denominated financial markets, are processes that many participants felt could take 10 or even 20 years. That said, it will be important to pay close attention to the growing use of the Yuan, particularly in the denomination of trade within Asia and between Asia and the emerging economies in Africa and Latin America.

These and other findings touch on trends, possible scenarios related to critical currencies, and the likely impact on the structure of the international monetary system, both in the long and the short term. Here at Davos, this topic is one on which thought leaders have approached me frequently. While sometimes a forbidding topic, it is nonetheless a call to action for governments and regulators, and remains a significant source of risk for both the financial sector and the real economy.

Chris Harvey is the Global Industry Leader of the Financial Services Industry group at Deloitte Touche Tohmatsu Limited (DTTL). He has more than 18 years of experience in consulting and leads the development and execution of the Deloitte organization’s strategy in the financial services industry. Previously, Chris led DTTL’s European Financial Services Strategy & Operations group.

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